BANKING SYSTEM AND MONETARY POLICY
x Discuss the two types of banks—commercial bank & central bank.
x The balance sheet of a commercial bank.
x The role of the banking system—how it generates money.
x What is the monetary system?
x Measures used by the central bank to affect money supply.
x The link between monetary policy and the real side of the economy—a revisit.
Types of Banks
There are two types of banks: commercial banks and central bank.
x Commercial banks are privately owned, profit-seeking institutions that provide a variety of financial services such as accepting
deposits from customers and making loans and other investments.
x In Canada, the banking industry is dominated by chartered banks.
x Chartered banks in Canada include RBC, BMO, CIBC, TD-Canada Trust, and Scotiabank.
x Chartered banks are subject to federal regulations and only until recently were required to hold reserves with the Bank of Canada
(BOC) against their deposit liabilities.
x The required reserve requirement was eliminated in 1994 but chartered banks still hold “voluntary” reserves with the BOC.
Central bank—the Bank of Canada (BOC)
x The BOC was established in 1935 and became a crown corporation in 1938.
x In practice, the operation of the BOC is independent of the Federal government (i.e., the government could not intervene into the
operation of the Bank of Canada).
x The BOC performs the following functions:
1) Print money & “in charge” of money supply
2) Lender of last resort: The BOC acts as bankers’ bank.
o If commercial banks need to borrow money to stay afloat or remain liquid, they can borrow from the BOC.
o However, there is no free lunch. When commercial banks borrow from the BOC, the BOC will charge them interest.
The interest rate that the BOC charged is called the bank rate.
3) Banker to Canadian government: BOC manages government bank accounts, foreign exchange reserves, and national debt.
The Balance Sheet of a Bank
x The balance sheet of a (commercial) bank:
Cash & reserves
x Cash & reserves—cash held by the commercial bank. Commercial bank keeps sufficient cash on hand to be able to meet the
depositor’s day-to-day requirements for cash.
x Equity—the difference between bank’s assets and bank’s liabilities.
The Reserve Ratio
x The reserve ratio (rr) refers to the fraction of its deposits that a commercial bank holds as cash & reserves.
o The reserve ratio is fraction Æ 1 > rr > 0.
x Before 1994, commercial banks were required to hold required reserves.
o The law required commercial banks to hold a minimum amount of cash as reserves for every dollar they accepted as deposits.
x Now, there is no required reserve requirement but banks do hold “voluntary” or target reserves. Why?
o To ensure that they have cash to satisfy daily withdrawals of the depositors Æ to avoid bank run.
x We should interpret the reserve ratio as the “target reserve ratio”—the fraction of deposits that commercial banks would like to
hold in the form of cash and reserves.
Commercial Banks and Money Creation
x This section examines how commercial banks help to create money.
The Set Up
x Initially there are no banks and total quantity of currency circulated is $200, all held by the public (currency in circulation = $200).
MS = currency in circulation + demand deposit
MS = $200 + $0 = $200
x Now, someone dreams up the idea of a “chartered bank” and opens one with $40 of cash invested in the bank (bank’s equity = $40).
o People can deposit their money in the bank.
o Once they open bank account and deposit money in their accounts, they can write cheques.
x Now, suppose that people deposit another $60 of their cash in the bank.
o The new bank has $100 in cash ($40 in equity, $60 in demand deposits).
x Assumption: People are happy with $100 in cash in their pockets, and they would deposit anything else into the bank (i.e., if they
have more than $100 in their pockets, they would deposit the “extra” cash in their bank accounts).
The chartered bank’s balance sheet—Beginning
Cash & reserves $100
Demand deposits $60
x Question: What is the level of MS (say M1) after the bank is established?
x Answer: M1 = currency in circulation + demand deposit
M1 = MS = $100 + $60 = $160 (MS decreases by $40)
How the Chartered Bank Creates Money?
x Now, let’s see how this newly found chartered bank helps to create money by making loans.
x Assumption: The target reserve ratio is 10% (rr = 0.1).
x Question: If the (target) reserve ratio is 10%, would the chartered bank be happy with its current position?
x Answer: No, the chartered bank is way out of equilibrium and is losing money.
o The bank is not generating any revenue (if the bank is not making any loan, how does the bank earn income?).
o However, the deposits will need to be paid back eventually (plus the interest paid to deposits).
o In this case, the bank holds excess reserves.
Actual reserve ratio = $100 / $60 = 1.67
Target reserve ratio = 0.1
: the bank holds excess reserves (actual reserve ratio > target reserve ratio)
x Question: What should the chartered bank do?
x Answer: try to decrease the reserve ratio to its target ratio (10%) by making loans
Indeed, the bank will keep making loans until the reserve ratio = 10%.
x Question: How does the bank lend money?
x Answer: By creating demand deposit.
o In real life, the bank does not really give you cash when it makes loans to you. The bank just creates a demand deposit with
your name on it so that you can draw on.
o When you spend that money (say writing cheques), then the money just goes from your account to someone else’s account.
The Chartered Bank Begins to Make Loans
Suppose the bank lends out $90.
x Question: What happens to the bank’s balance sheet?
The bank’s balance sheet—Immediately after $90 in loan
Cash & reserves $100
Loans $0 + $90
Demand deposits $60 + $90
x Note: The bank still holds excess reserves.
Target reserve ratio = 0.1
Actual reserve ratio = $100 / $150 = 2/3 = 0.67
: this is still higher than the target reserve ratio
: continue to make more loans
x The key is that the new demand deposits never actually leave the system!
The Chartered Bank Continues to Make Loans
What happens if the bank continues to make loans so that the reserve ratio is eventually equal to the target ratio of 10%?
x The maximum amount of demand deposits that would be supported by the initial $100 reserves is:
0.1 = $100 / DD
DD = $1000 (this is the maximum amount of demand deposits that the bank can make)
x Question: What would the final balance sheet of the chartered bank look like?
The bank’s balance sheet—when reserve ratio reaches it target ratio.
Cash & reserves $100
Demand deposits $1000 = $60 + $940
x It seems that the banking system has seemingly “created” $940 loans in new money. Why?
MS = currency in circulation + demand deposits
“Final” MS = $100 (cash held by the public) + $1000 (total DD in bank) = $1100
ûMS = “Final” MS – Initial MS (when the bank is found) = $1100 – $160 = $940 (ûMS = amount of loans created by bank)
x Question: How could the chartered bank create money? Is this a trick?
x Answer: No, there is no trick. The banking system DOES CREATE money! We call this money creation.
o As the bank loans out money, this money gets deposited back into the banking system, which is then available for the bank to
loan out again. Then, more loans are being created and get re-deposited back into the banking system Æ MS increases.
o In our example, the process continues until the reserves reach its target ratio; i.e., the bank will keep making loans until its
reserves are 10% of the demand deposits.
The role of the banking system how it generates money. N discuss the two types of banks commercial bank & central bank. N measures used by the central bank to affect money supply. There are two types of banks: commercial banks and central bank. N commercial banks are privately owned, profit-seeking institutions that provide a variety of financial services such as accepting. The link between monetary policy and the real side of the economy a revisit. deposits from customers and making loans and other investments. In canada, the banking industry is dominated by chartered banks. N chartered banks in canada include rbc, bmo, cibc, td-canada trust, and scotiabank. N chartered banks are subject to federal regulations and only until recently were required to hold reserves with the bank of canada (boc) against their deposit liabilities. The required reserve requirement was eliminated in 1994 but chartered banks still hold voluntary reserves with the boc.